Is factor investing dying?

Equities 6 minutes to read

Peter Garnry

Head of Equity Strategy

Summary:  In 2018 we presented the idea that the momentum factor was dead showing evidence from Fama-French data. A month ago a new paper suggests that the momentum factor is experiencing severe crowding effects detriment to the factor's alpha generation. We believe this destiny is now hitting all factors including the beloved value factor. Investors are entering new waters were new methods have to be invented in order to survive. For the retail investor we propose a shift away from momentum, value, quality etc. and want investors to think about themes. In this game the human actual has a chance against the machine.


Back in October 2018 we raised the issue that the famous momentum strategy had potentially hit the point where it was arbitraged away due to more computing power and a wave of funds and ETFs utilizing the momentum factor. We highlighted the AQR Large Cap Momentum Style Fund and its failure to beat the S&P 500. Our main point back then and even more so today is that simple strategies will be arbitraged away.

Adding support for our view a January 2020 paper by Bouchaud et. al. Zooming In on Equity Factor Crowding argues that crowding effects are now very visible in Fama-French factors such as the momentum. The abstract says:

Crowding is most likely an important factor in the deterioration of strategy performance, the increase of trading costs and the development of systemic risk. We study the imprints of crowding on both anonymous market data and a large database of metaorders from institutional investors in the U.S. equity market. We propose direct metrics of crowding that capture the presence of investors contemporaneously trading the same stock in the same direction by looking at fluctuations of the imbalances of trades executed on the market. We identify significant signs of crowding in well known equity signals, such as Fama-French factors and especially Momentum. We show that the rebalancing of a Momentum portfolio can explain between 1-2% of order flow, and that this percentage has been significantly increasing in recent years.

In a Tweet thread yesterday we proposed that the value factor is also dead. Our main point is that the market has become so efficient now that no one-dimensional feature set can any longer produce alpha. The amount of computing power available and access to fundamental data and methodology agreement on what is the value factor on top of many funds and ETFs using the value factor has eroded the signal. The chart below shows the 5-year rolling mean monthly return between value and growth stocks. Since the financial crisis in 2008 value investors have been in one long pain trade due to massive underperformance by financials and energy stocks.

Even Research Affiliates’ attempt to rectify and enhance the value factor by capitalizing intangible assets will save the future for the value factor. It’s still one-dimensional and our hypothesis is that the market is now efficiently pricing growth differentials more or less accurately. In other words, the valuation differences do no longer represent mispricing but approximately correct assessment of future growth. The approximation is what leads to volatility in the factor signal but importantly the volatility represents noise that cannot accurately be captured by timing models.

So what is the future for factor investing? Well the obvious thing that comes to mind is blending multiple factors. This can be done in many ways, but the current version in US equity markets by iShares is not doing very well against the S&P 500 either on returns or downside characteristics. The underperformance has been 2.7% annualized since May 2015. But again if single factors are getting arbitraged away why would a mix of them work?

Source: Saxo Group

The edge in quantitative strategies lie in alternative (unstructured) and high quality datasets. With time these will be arbitraged away but not anytime soon. For investors thinking what do next our view is that retail investors with a longer time horizon than below a month should think in themes. Our recent “green stocks” theme is one way to identify interesting stocks that can give an edge over the long run a playground not suitable for machines.

Disclaimer

Saxo Capital Markets (Australia) Pty Ltd prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Combined Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Pty Ltd ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide and Product Disclosure Statement to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products such as CFDs and Margin FX products may result in your losses surpassing your initial deposits. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.
Please click here to view our full disclaimer.